The Debt Crisis – Why Gold will explode

August 15, 2012

The international debt crisis is considered to be a European problem, though is far more widespread than the handful of Eurozone nations that have, thus far, required a bailout. Indeed, most of Europe, certainly its main nations, has been building up their debt positions for the last two decades or more as successive governments have borrowed to spend.

Europe’s nations owe a total of around €10 trillion ($12.5 trillion), and over 80% of that is owed by the 17 Eurozone countries, including Germany, whose debt is around 80% of its GDP. The UK’s debt is around the same level as Germany’s when measured against its GDP.

To combat the problem of debt, certain European nations have, in effect, declared themselves bankrupt and received ‘bailout’ money from the ECB and Europe. Whist it is a complicated method by which this money is passed over to the needy nation, effectively Europe is borrowing more money to pay its debts: it is increasing its debts to service its debts.

Meanwhile, in the United States, debt has now risen to over $15 trillion. This debt is being serviced by the issuance of bonds. Interest rates are being kept low, so that debt repayment is more manageable. This is the same in Europe.

Of course, what this has meant in Europe is that the economy is now declining rapidly as austerity measures are put into place to help combat its debt. Countries that have accepted bailout cash have had also to accept their budgets being scrutinised by and controlled by the European central authorities. This has not been popular with the populace, and neither has Germany’s role as ‘lender of last resort’ to its European neighbours.

In America, it would appear that hopes are pinned on economic recovery to get its debts paid off, or at least down to a manageable level. It too has low interest rates.

It has been estimated that the US economy would have to grow by 6% per year to service its debts and cut them over the next twenty years: it is running an annual deficit of around $1.5 trillion. Of course, it could choose the European option and cut spending drastically, which will send the economy into a tailspin.

It might decide to raise taxes, but what government would commit political suicide by doing so? Besides, if taxes are raised, spending in the economy would fall, jobs would be lost, and the economy decline.

So far, the US has cut interest rates to historic levels, and pumped hundreds of billions into its economy by way of quantitative easing measures. Yet the economy has only grown by around 1.5% per annum through the first half of 2012, and appears to be slowing further.

It could, of course, borrow more money to pay its way in the world. At some point, though, lenders will thin out – China has already threatened to reduce the number of US bonds that it buys – and debt will have to be repaid.

Perhaps the US will do the unthinkable and default on its debts? If it does this, the US dollar will collapse, the economy fall into depression, and the world never be the same again.

In reality all of the measures open to the US have been employed in Europe through the course of 2011/ 12. And yet the economy in Europe continues to weaken, debt continues to rise, as does unemployment, and tax revenue is falling. The Euro has weakened against all major currencies.

The most likely option open to the US government to combat its debt is to allow the dollar to weaken. This will mean that it can repay its debt more quickly in foreign currency terms, and make its exports cheaper. This could increase economic activity, though inflation would rise.

Whatever course of action the United States’ and Europe finally decide upon to tackle debt, it looks likely that inflation will rise and economic activity contract. Both of these results would be good news for the price of gold.

The major ratings agencies have downgraded sovereign debt across much of Europe, and it cannot be ruled out that similar could be on the cards for US credit ratings. Were this to happen, then the dollar would suffer. Dollar weakness is bullish for the gold price, gold being seen as a store of value.

As austerity measures have been put in place in Europe, the voting population has fought against rising taxes and cuts in public wages and spending. This political unrest has seen many governments change political colour through the last 12 months. Political upheaval is also good for gold.

The economic and political problems facing America and Europe, the world’s two largest economic areas, have been caused almost entirely by a build-up of debt. At some time this debt will boil over. If a solution to the debt problem has not been found before this happens, then the price of gold will explode.